Forcing investors to bid through dealers during Government of Canada bond auctions distorts the market, according to a new report published by the National Bureau of Economic Research.

The paper, by Ali Hortacsu from the University of Chicago and Samita Sareen of Duke University, finds that customers are at a disadvantage because dealer access to order flow information is significant.

The paper examines at the behaviour of dealers and non-dealer investors in these auctions, and concludes that, “customer bids provide valuable order-flow information to dealers.”

Since being informed about customer bids gives an advantage to a dealer, dealers modify their bids on the basis of customer order-flow information. Customers try to defend themselves against dealers’ use of their information by delaying their bids.

“There are policy implications of this simple model, but these implications should be interpreted cautiously,” the paper concludes. “The main and unambiguous policy implication of the model is that forcing customers to bid through dealers distorts the efficiency of the allocation. One may hope that any such efficiency losses will be remedied in the secondary market; but this hope hinges on the lack of transaction costs in the secondary market.”

“The second policy implication of our simple model is that the effect of the current bidding rules on the revenues of the Government of Canada may depend sensitively on the exact specification of the model,” it says. Adding, “An accurate characterization of the revenue impact of the current bidding rules will require the use of a model that provides a much closer approximation to institutional reality.”